Strategic asset allocation for pension funds
by Dr. Ros Altmann
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In the realm of strategic asset allocation, the investment aims of defined benefit and defined contribution schemes are different. Trustees need to consider this carefully. In the past, the investment objectives of final salary schemes have typically been thought of as ‘maximising returns, while minimising risk’, which trustees often translated as outperformance of an index or peer group benchmark, relying heavily on equities to generate superior long term returns. It was confidently assumed that equities must perform better over longer time horizons and downside risks were not really considered.
However, the real objective should surely be to match or (especially if there is a deficit) outperform the liabilities. Trustees are responsible for ensuring members’ pensions are delivered. They should not be concerned with ensuring the company can fund pension promises as cheaply as possible. This means that targeting outperformance of the pension liabilities, rather than indices, is optimal. These liabilities are linked to inflation (both salary inflation for non-pensioners and limited price inflation for pensioners) and to longevity. However, the liabilities are not linked to equity market returns. Therefore, achieving the benefits of long term equity outperformance may be good for maximisation of assets, but having a larger pool of assets, per se, does not necessarily matter to provision of the final salary pension. The employer is supposed to stand behind the promise. Surpluses do not necessarily generate higher pensions, if they simply lead to lower employer contributions, whereas deficits could lead to loss of pension, if employers cannot afford to make up the shortfalls. Relying heavily on equities is not a ‘one-way’ bet, especially in a mature scheme or with a weak employer.
However, for defined contribution schemes, investment aims are different. There is no ‘pensions promise’ and the liabilities are pensions which must usually be secured by annuities. The greater the assets, the bigger the pension is likely to be. There are four critical factors which will determine the eventual size of any defined contribution pension. Apart from the contribution levels (not really a matter for trustees) there is investment performance, the level of charges and finally the costs of annuity purchase (or other means of securing pension-type income). Trustees can influence all three of these factors, but I would argue that they are only slowly waking up to these challenges.
In many cases, trustees offer little or no choice for members’ investments. Sometimes just a balanced fund, with-profits fund or ‘lifestyle’ option. Very often, only one providers’ products are offered and little ongoing monitoring of this provider or the investment options is conducted. This leaves the members without the chance to construct truly well-diversified portfolios and leaves trustees exposed to claims that they did not offer members sufficient chance to maximise their pensions.
As to the question of charges, trustees should focus carefully on choosing suppliers with the lowest fee levels, or giving members access to low-cost index-tracking funds, where the risk of underperformance should be reduced. Exorbitant charges can seriously erode pension assets over time.
Of course, even if members are offered a range of products, most are afraid to choose for themselves and simply select the ‘default option’. This forces members into a ‘one size fits all’ investment vehicle, which may not be best for them. The financial services industry has been slow to develop a good range of default options for money purchase pensions, catering for different members’ needs. For example, products to suit different age groups and different risk appetites, or possibly a capital protected vehicle for those typical private investors whose idea of risk is ‘will I lose money?’. Perhaps for members who do not own their own home, an investment vehicle which includes property assets could be attractive.
As regards securing the ultimate pension, I would argue that trustees’ investment duties should also include shopping around for the best annuities for their members. Enhanced rates, impaired lives, guarantee periods and the big differentials in market annuity rates would all suggest that trustees must take great care when selecting an annuity for their retiring members. Impaired life annuities can give members 30-50% higher pensions. Appropriate annuity choice is particularly crucial because the members can never change the annuity for the rest of their lives. Once bought, they are stuck with it and, if trustees cannot demonstrate that they took due care before selecting the annuity, might members be tempted to seek redress?
In summary, as defined benefit schemes become more mature and defined contribution schemes increase, trustees should urgently reconsider their investment thinking. Defined benefit trustees must focus on outperforming liabilities. Money purchase trustees should ensure that they are offering members access to a suitably wide range of investment choices and default options, ensure charges are minimised and focus carefully on ensuring that the annuity purchase decisions are made with due care.